Academic journal article Journal of Accountancy

Clear Reflection of Income

Academic journal article Journal of Accountancy

Clear Reflection of Income

Article excerpt

As a general rule taxpayers have the right to select their method of accounting--but this right is restricted by the requirement that the selected method clearly reflect income. Recently, the Seventh Circuit Court of Appeals remanded a case to the Tax Court to redetermine the method the taxpayer selected.

JP Morgan Chase, successor to First National Bank of Chicago, engaged in interest rate swaps. These are complex financial transactions that require two parties to pay each other interest based on various factors. Chase reported the income from these swaps based on its financial accounting method. The IRS objected and assessed a deficiency based on its own method. The Tax Court rejected both methods and imposed a third. JP Morgan Chase appealed.

Result. JP Morgan Chase's method was incorrect. The case was remanded for the Tax Court to reconsider the IRS method.

IRC section 446(a) requires taxpayers to compute their taxable income based on the accounting methods used in their books and records. Under section 446(b), the IRS can impose a different method if a taxpayer's selected method does not clearly reflect income. The fact that the taxpayer's method is based on GAAP does not mean it clearly reflects income. These general rules concerning selection of accounting methods give way to specifically designated methods in the tax code.

One such designated method is the mark-to-market method, which must be used by dealers in financial instruments. …

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